Deducting “Tax Insurance” Premiums

 There is an insurance type that I have never worked with professionally: tax liability insurance.

It is what it sounds like: you are purchasing an insurance policy for unwanted tax liabilities.

It makes sense in the area of Fortune 500 mergers and acquisitions. Those deals are enormous, involving earth-shaking money and a potentially disastrous tax riptide if something goes awry. What if one the parties is undergoing a substantial and potentially expensive tax examination? What if the IRS refuses to provide advance guidance on the transaction? There is a key feature to this type of insurance: one is generally insuring a specific transaction or limited number of transactions. It is less common to insure an entire tax return.  

My practice, on the other hand, has involved entrepreneurial wealth – not institutional money - for almost my entire career. On occasion we have seen an entrepreneur take his/her company public, but that has been the exception. Tax liability insurance is not a common arrow in my quiver. For my clients, representation and warranty insurance can be sufficient for any mergers and acquisitions, especially if combined with an escrow.

Treasury has been concerned about these tax liability policies, and at one time thought of requiring their mandatory disclosure as “reportable” transactions. Treasury was understandably concerned about their use with tax shelter activities. The problem is that many routine and legitimate business transactions are also insured, and requiring mandatory disclosure could have a chilling effect on the pricing of the policies, if not their very existence. For those reasons Treasury never imposed mandatory disclosure.

I am looking at an IRS Chief Counsel Memorandum involving tax liability insurance.

What is a Memorandum?

Think of them as legal position papers for internal IRS use. They explain high-level IRS thinking on selected issues.

The IRS was looking at the deductibility by a partnership of tax insurance premiums. The partnership was insuring a charitable contribution.

I immediately considered this odd. Who insures a charitable contribution?

Except …

We have talked about a type of contribution that has gathered recent IRS attention: the conservation easement.

The conservation easement started-off with good intentions. Think of someone owning land on the outskirts of an ever-expanding city. Perhaps that person would like to see that land preserved – for their grandkids, great-grandkids and so on – and not bulldozed, paved and developed for the next interchangeable strip of gourmet hamburger or burrito restaurants. That person might donate development rights to a charitable organization which will outlive him and never permit such development. That right is referred to as an easement, and the transfer of the easement (if properly structured) generates a charitable tax deduction.

There are folks out there who have taken this idea and stretched it beyond recognition. Someone buys land in Tennessee for $10 million, donates a development and scenic easement and deducts $40 million as a charitable deduction. Promoters then ratcheted this strategy by forming partnerships, having the partners contribute $10 million to purchase land, and then allocating $40 million among them as a charitable deduction. The partners probably never even saw the land. Their sole interest was getting a four-for-one tax deduction.

The IRS considers many of these deals to be tax shelters.

I agree with the IRS.

Back to the Memorandum.

The IRS began its analysis with Section 162, which is the Code section for the vast majority of business deductions on a tax return. Section 162 allows a deduction for ordinary and necessary expenses directly connected with or pertaining to a taxpayer’s trade or business.

Lots of buzz words in there to trip one up.

You my recall that a partnership does not pay federal tax. Instead, its numbers are chopped up and allocated to the partners who pay tax on their personal returns.

To a tax nerd, that beggars the question of whether the Section 162 buzz words apply at the partnership level (as it does not pay federal tax) or the partner level (who do pay federal tax).

There is a tax case on this point (Brannen). The test is at the partnership level.

The IRS reasoned:

·      The tax insurance premiums must be related to the trade or business, tested at the partnership level.

·      The insurance reimburses for federal income tax.

·      Federal income tax itself is not deductible.

·      Deducting a premium for insurance on something which itself is not deductible does not make sense.

There was also an alternate (but related argument) which we will not go into here.

I follow the reasoning, but I am unpersuaded by it.

·      I see a partnership transaction: a contribution.

·      The partnership purchased a policy for possible consequences from that transaction.

·      That – to me - is the tie-in to the partnership’s trade or business.

·      The premium would be deductible under Section 162.

I would continue the reasoning further.

·      What if the partnership collected on the policy? Would the insurance proceeds be taxable or nontaxable?

o  I would say that if the premiums were deductible on the way out then the proceeds would be taxable on the way in.

o  The effect – if one collected – would be income far in excess of the deductible premium. There would be no further offset, as the federal tax paid with the insurance proceeds is not deductible.

o  Considering that premiums normally run 10 to 20 cents-on-the-dollar for this insurance, I anticipate that the net tax effect of actually collecting on a policy would have a discouraging impact on purchasing a policy in the first place.

The IRS however went in a different direction.

Which is why I am thinking that – albeit uncommented on in the Memorandum – the IRS was reviewing a conservation easement that had reached too far. The IRS was hammering because it has lost patience with these transactions.

This Is Why We Cannot Have Nice Things

I am looking at a case involving a conservation easement.

We have talked about easements before. There is nothing innately sinister about them, but unfortunately they have caught the eye of people who have … stretched them beyond recognition.

I’ll give you an example of an easement:

·      You own land in a bucolic setting.

·      It is your intention to never part with the land.

·      It is liturgy to the beauty and awe of nature. You will never develop it or allow it to be developed.

If you feel that strongly, you might donate an easement to a charitable organization who can see to it that the land is never developed. It can protect and defend long after you are gone.

Question: have you made a donation?

I think you have. You kept the land, but you have donated one of your land-related legal rights – the right to develop the land.

What is this right worth?

That is the issue driving this area of tax controversy.

What if the land is on the flight path for eventual population growth and development? There was a time when Houston’s Galleria district, for example, was undeveloped land. Say you had owned the land back when. What would that easement have been worth?

You donated a potential fortune.

Let’s look at a recent case.

Plateau Holdings LLC (Plateau) owned two parcels of land in Tennessee. In fact, those parcels were the only things it owned. The land had been sold and resold, mined, and it took a while to reunite the surface and mineral rights to obtain full title to the land. It had lakes, overlooks, waterfalls and sounded postcard-worthy; it was also a whole lot out-of-the-way between Nashville and Chattanooga. Just to get utilities to the property would probably require the utility company to issue bonds to cover the cost.

Enter the investor.

He bought the two parcels (actually 98.99%, which is close enough) for approximately $5.8 million.

He worked out an arrangement with a tax-exempt organization named Foothills Land Conservancy. The easement would restrict much of the land, with the remainder available for development, commercial timber, hunting, fishing and other recreational use.

Routine stuff, methinks.

The investor donated the easement to Foothills eight days after purchasing the land.

Next is valuing the easement

Bring in the valuation specialist. Well, not actually him, as he had died before the trial started, but others who would explain his work. He had valued the easement at slightly over $25 million.

Needless to say, the IRS jumped all over this.

The case goes on for 40 pages.

The taxpayer argument was relatively straightforward. The value of the easement is equal to the reduction in the best and highest use value of the land before and after the granting of the easement.

And how do you value an undeveloped “low density mountain resort residential development”? The specialist was looking at properties in North Carolina, Georgia, and elsewhere in Tennessee. He had to assume government zoning, that financing would be available, that utilities and roads would be built, that consumer demand would exist.

There is a flight of fancy to this “best and highest” line of reasoning.

For example, I would have considered my best and highest professional “use” to be a long and successful career in the NFL. I probably would have been a strong safety, a moniker no longer used in today’s NFL (think tackling). Rather than playing on Sundays, I have instead been a tax practitioner for more than three decades.

According to this before-and-after reasoning, I should be able to deduct the difference between my earning power as a successful NFL Hall of Famer and my actual career as a tax CPA. I intend to donate that difference to the CTG Foundation for Impoverished Accountants.

Yeah, that is snark.

What do I see here?

·      Someone donated less than 100% of something.

·      That something cost about $6 million.

·      Someone waited a week and gave some of that something away.

·      That some of something was valued at more than four times the cost of the entire something. 

Nah, not buying it.

Neither did the Court.

Here is one of the biggest slams I have read in tax case in a while:

           We give no weight to the opinion of petitioner’s experts.”

The taxpayer pushed it too far.

Our case this time for the home gamers was Plateau Holdings LLC v Commissioner.

The $64 Million Question

Let’s talk about hard rules in the tax Code.

Let’s say that you donate $500 to your church or synagogue. You come to see me to prepare your taxes. I ask you whether you have received a letter concerning that $500 donation.

You think that I am a loon. You after all have the cancelled check. What more does the government want?

That’s the problem.

Here’s the rule:

A single contribution of $250 or more – whether by cash, check or credit card – must be supported by a receipt that meets the following requirements:

a.    It must identify the amount.

b.    It must state that no goods or services were given in exchange (alternatively, it must subtract said goods and benefits from the donation if such were given); and

c.     The taxpayer must have such receipt before filing his/her tax return.

To restate this: you can give the IRS a cancelled check and it will not be enough to save your contribution deduction - if that deduction is over $250.

The tax Code is spring-loaded with traps like this. Congress and the IRS say this is necessary for effective tax administration. Nonsense. What they are interested in is taking your money.

There is a super-sized type of charitable deduction known as an “easement.” Think real property, like land or a building. The concept is that real estate is a combination of legal rights: the right to ownership, to development, to habitation, to just leave it alone and look at it.

Let’s say that you own a historical building in name-a-town USA. Chances are that restrictions are in place disallowing your ability to upsize, downsize, renovate the place or whatever. You decide to donate a “façade” easement, meaning that you will not mess with the exterior of the building. Well, messing with the exterior of the building is one of those legal rights that together amalgamate to form real estate, and you just gave one such right away. Assuming that a value can be placed on it, you may have a charitable donation.   

There are a couple of questions that come to mind immediately:

(1) Depending upon the severity of town restrictions, you may not have had a lot of room to alter the exterior anyway. You may not have given away much, in truth.

(2) Even hurdling (1), how do you value the donation?

Sure enough, there are people who value such things.

That is one thing about the tax Code: Congress is always employing somebody to do something whenever it changes the rules, and it is forever changing the rules. Virtually all tax bills are jobs bills. We can question whether those jobs are useful to society, but that is a different issue.

You will not be surprised that a super deduction brings with it super rules:

(1) One must attached a specific tax form (8283)

(2) One must attach a qualified appraisal

(3) One must attach a photograph of the building exterior

(4) One must attach a description of all restrictions on the building

There is an LLC in New York that claimed a 2007 easement deduction of $64.5 million.

Folks, you know this is going to be looked at.  

Let’s set the trap:

The LLC received a letter from the charity acknowledging the easement. Assuming the return had been extended, this would have been a timely letter.

However, the letter did not contain all the “magic words” necessary to perform the required tax incantation. More specifically, it did not say whether the charity had provided any benefits to the LLC in return.

Guess who gets pulled for audit in 2011? Yeah, a $64 million-plus easement donation will do that.

While preparing for audit, the tax advisors realized that they did not have all the magic words. They contacted the charity, which in turn amended its 2007 Form 990 to upgrade the information provided about the donation.

Strikes you as odd?

Here is what the LLC was after:

IRC Section 170(f)(8):

(A) General rule

No deduction shall be allowed under subsection (a) for any contribution of $250 or more unless the taxpayer substantiates the contribution by a contemporaneous written acknowledgment of the contribution by the donee organization that meets the requirements of subparagraph (B).

(D) Substantiation not required for contributions reported by the donee organization

Subparagraph (A) shall not apply to a contribution if the donee organization files a return, on such form and in accordance with such regulations as the Secretary may prescribe, which includes the information described in subparagraph (B) with respect to the contribution.

The LLC was after that “(A) shall not apply if the donee organization files a return” language. The charity amended its return, after all, to beef-up its disclosure of the easement donation.

Nix, said the IRS. All that hullabaloo was predicated on “regulations as the Secretary may prescribe.” And guess what: the Secretary did not prescribe Regulations.

Do you remember about a year ago when we talked about charitable organizations issuing 1099-like statements to their donors? We here at CTG did not care for that idea very much, especially in an era of increasing identity theft. Many charities are small and simply do not have the systems and resources to secure this information.

Well, that was also the IRS trying to prescribe under Section 170(f)(8)(D). You may remember the IRS took a tremendous amount of criticism, after which it withdrew its 1099-like proposal.

The LLC argued that Congress told the IRS to issue rules under Section 170(f)(8)(D) but the IRS did not. It was unfair to penalize the LLC when the IRS did not do its job.

The IRS took a very different tack. It argued that Section 170(f)(8)(D) gave it discretionary and not mandatory authority. The IRS could issue regulations but did not have to. In the jargon, that section was not “self-executing.”

The Tax Court had to decide a $64 million question.

And the Tax Court said the IRS was right.

At which point the LLC had to meet the requirements discussed earlier, including:

The taxpayer must have such receipt before filing his/her tax return.

It had no such receipt before filing its return.

It now had no $64.5 million deduction. 

The taxpayer was 15 West 17th Street, and they ran into an unforgiving tax rule. I am not a fan of all-or-nothing-magic-tax-incantations, as the result appears ... unfair, inequitable, almost cruel ... and as if tax compliance is a cat-and-mouse game.

Getting A Tax Deduction From A Golf Course

Have you heard about Louis Bacon? He is the manager for the hedge fund Moore Capital Management. No, I am not mentioning his name because I am a client of his firm (I wish), but because I was reading that he donated a conservation easement, meaning that he got a (sizeable, I’m certain) tax deduction. The easement is on his Colorado ranch, Trinchera Blanca, which extends over 90,000 acres.

COMMENT: I wonder how long it takes to reach your house upon turning from the roadway when your property is 90,000 acres.      

This gives us an opportunity to talk about conservation easements. Let’s be upfront, however: this is a high-end tax strategy. This has as much to do with your or my daily life as piloting a fighter jet.  

There are three requirements if you want this deduction: 

• Qualifying real property
• Donated to a qualified organization
•  For conservation purposes

The third requirement includes:

• The preservation of land for substantial and regular use by the public for outdoor recreation or education
• The protection of natural habitat of fish, wildlife or plants
• The preservation of open space, where the preservation is for public enjoyment or pursuant to government conservation policy
• The preservation of historically important land or a certified historic structure

An easement makes sense if you think of real estate as more than just … well, real estate. Let’s say, for example, that you own the last remaining farm in a now heavily-developed suburban area. That farm is more than just soil. It is also a bucolic view, a possible watershed, the remaining redoubt for an endangered amphibian, and the source of great wealth from a potential sale to developers. It has layers, like a good lasagna.

We are going to donate one or more of those layers to a charity. We might be able to fit under the “preservation of open space” category above, for example. You could donate a restriction that the property will never be commercially developed. You still own the farm, mind you, but you have donated one of the rights which as a bundle of rights comprise your full ownership of the property.

We next have to put a value on this layer. This is where the horsepower to the conservation easement kicks in.

Let’s say that our farm has been in the family since before there were telephones. Chances are that its cost is relatively negligible.

COMMENT: Before someone comments, I know that the property’s basis would have been reset to its fair market value when it transferred at an ancestor’s death. Let’s compromise and say that the family is extremely long-lived.

Meet a few qualifications and that pennies-on-the-dollar cost has nothing to do with calculating the deduction. We instead are going to get an appraiser to value the property, and he/she is likely to value the easement as follows:

• The value of the property intact and before any donation, less
• The value of the property after the donation of the easement

The numbers can get impressive.

There is a famous case, for example, about an easement in Alabama.

The story begins with Mr. E.A. Drummond, who bought 228 acres on the Fort Morgan peninsula in 1992 for $1,050,000. Two years later he started a planned resort community featuring a 140.9 acre golf course. He started selling lots in 1995, and in 2002 he transferred the golf course to an entity known as Kiva Dunes.

He then donated a perpetual conservation easement on Kiva Dunes.

Kiva Dunes

He valued the easement at over $30 million.

Kiva Dunes also wrote a check to the charity for $35,000.

The IRS got wind of this and they were unamused. They disallowed the $30 million. They also disallowed the $35,000 cash donation, which seems odd. They must have been having a very cranky week.

The case went to Tax Court. The IRS immediately backed off on the fact of a donation, perhaps because by then they were having a better week. They argued instead on the amount of the easement donation. Mr. Drummond brought in an expert who had lived and worked in the area for decades and performed more appraisal work there than anyone else. The IRS brought an expert from Atlanta who had visited the peninsula only twice, and that was to appraise Kiva Dunes.

You can guess which appraiser was more persuasive. The Court reduced the donation to a little over $28 million, which means they effectively agreed with Mr. Drummond. It was a landmark taxpayer win.

The Administration did not like this result at all. They were quite determined to shut down golf course conservation easements, although little has occurred since. They had a point. After all, we are talking about a golf course.

The benefit of a conservation easement on a private golf course, especially in a luxury development, is likely to accrue to a limited number of people and not to the general public. You or I may not even be permitted to drive through some of these communities, much less see or otherwise enjoy the easement.

On the flip side, I have a friend who used to install golf courses in Cincinnati, primarily on the northern Kentucky side. For the locals, I helped him with one of the greens at Devou Park Golf Course, although I do not remember how he talked me into it. I presume I was temporarily insane. Nonetheless, he was very passionate about golf courses serving as respites and nature sanctuaries in otherwise developed urban environments. Kiva Dunes, for example, included broad swaths of wetlands which served as a stopover for migratory birds, as well as being home for a number of threatened species.

One can argue - if there is a socially-desirable ecological, wildlife or preservation outcome – whether it matters that the benefits will be enjoyed by the few. What is of true import here: ecology, wildlife and preservation or the politics of envy? Non-wealthy people do not donate easements. The alternative, unfortunately, is to do … nothing.  

Kiva Dunes had a point.

However, a $28 million point?

One can see the controversy.